Income Tax in Canada
Understanding the progressive tax system
The key to understanding how you can best use an RRSP, RESP or TFSA is knowing how you are taxed on your income.
Canada has a progressive tax system, which means that as you earn more money, you pay a higher percentage on that money. This system helps to distribute wealth more evenly across the population.
The most important term to know is "marginal tax rate". Your marginal tax rate is the percentage of tax you pay on the next dollar you earn. For example, someone in Ontario earning $48,000 a year pays 24.15% income tax on the next dollar they earn while someone earning $97,000 a year will pay 37.9% on the next dollar.
The reason we say "on the next dollar they earn" is because everyone pays the same percentage tax rate on dollar number 48,001 (24.15%). But as you make more money, you enter a higher tax bracket, and the percentage you pay goes up. This means that you might have a different average tax rate than your neighbour. The average tax rate is the total amount of income tax you paid last year divided by your income.
"Income" means employment income, investment income (interest, capital gains, dividends), rental income, and money you get from pensions and social assistance payments.
The chart below shows the average and marginal tax rates for various income levels. A person earning $80,000 a year will pay 21% in taxes, and for each additional dollar earned, will pay 31% in tax.
What does this mean for me?
You can use registered accounts to lower the taxes you pay
There are three ways this happens.
Get a tax benefit up front (as with an RRSP).
Have the earnings in the account taxed at a lower tax rate once you take it out of the account (RRSP and RESP)
Owe no tax at all in investment earnings (TFSA).
RRSP: The premise behind using an RRSP is that every contribution you make into the account can be deducted from your income. This means you will pay less income tax. For example, if you earned $60,000 and made a $10,000 RRSP contribution, you only pay tax on $50,000 of income. This would amount to a tax savings of $2,965 (29.65% of $10,000). RRSPs are really valuable for people who are earning more now than they will be in retirement. This is because once you take that $10,000 out of your RRSP when you are 65, you will pay tax on it. The assumption is that you will be earning less money then, and will therefore be in a lower tax bracket so you pay less tax.
RESP: When you put money in an RESP you don't get to subtract that amount from your income for tax purposes. The benefit of an RESP is that as long as the money is used for your child's education (or whoever is the named beneficiary on the account) you don't have to pay any income tax on any money earned on the savings (interest, capital gains, dividends). Once your child goes to school and takes the money out, they are responsible for paying the tax...but of course they likely won't be earning a lot of money and will be in a low tax bracket, so will pay little to no tax on that money.
TFSA: The TFSA is the simplest of accounts. Any earnings you make on the money in the account (interest, capital gains, dividends) is never taxed. Not ever. Not even when you take the money out. Simple.
Anything else I need to know?
RRSPs don't make sense for everyone
There seems to be an assumption that everyone should contribute to an RRSP. This isn't true. RRSPs usually don't make sense for people in low tax brackets. For some people, the TFSA should be maximized first. There are lots of nuances about how to best use RRSPs and the value of using it needs to be determined on a case-by-case basis.
RRSPs, TFSAs and RESPs all have rules and restrictions
The basic idea behind these accounts is simple, but don't get caught by the details! You can read more on each account on the "I Have So Many Questions" page and do more research. Or, talk to someone with financial expertise.
Not all income is taxed the same way
Employment income is fully taxable but some other forms of income are not. To encourage people to invest, income taxes payable on dividends and capital gains are lower than on regular employment income. This doesn't matter when they are invested in an RRSP, RESP or TFSA but makes a difference when you are investing in a non-registered account.